Legitimate Mlm Or Pyramid Scheme How Can You Tell

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As an attorney in the network marketing industry, I’m most often asked the question “What in the world is an MLM attorney?” After doing my best to answer that question, and oftentimes feeling like I’ve just spoken in tongues, the next question is always “Is this XYZ business I’m in an illegal pyramid scheme?” The answer is always the same.

It depends

The analysis is always fact-driven, meaning a number of factors need to be considered. Although there is a cheat-sheet / mathematical formula available to help measure the legality of a business, it unfortunately requires sensitive data from a company that is never publicly available. So if you really need a concrete answer, you need to sue the company, get the data via discovery requests and depositions, hire a professional expert at $500 an hour to plug in the numbers, and then, $100,000 later (if you're lucky), you’ll have your answer.

The Federal Trade Commission has recently admitted to the challenge of distinguishing between legitimate companies and pyramid schemes. They said:

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While there is a significant concern that some pyramid schemes masquerade as legitimate MLMs, assessing the incidence of such practices is difficult...While economic analysis can reveal if an individual company is operating legitimately or if it clearly is a pyramid scheme, it is difficult to draw an appropriate line in the gray area.1

In 2009, I published an ebook titled “Pyramid Schemes: Saving the network marketing by defining the gray”that calls for regulators and legislators to “define the gray” between legitimate MLMs and pyramid schemes masquerading as MLMs. But until the gray gets defined, we’ve got to follow our gut instincts.

1 Federal Register, Revised Proposed Business Opportunity Rule, 16 C.F.R. 437, p. 36 (proposed March 18, 2008), available at http://www.ftc.gov/os/2008/03/R511993business.pdf

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Legitimate network marketing companies pay commissions on the sale of products and services to customers. The issue of legitimacy hinges on the definition of "customer" and the amount of revenue required to come from customers, not distributors. Legally, companies are required to generate a substantial amount of revenue from customers outside the program. Is it ok if 99% of a company's revenue

comes from its distributors buying the products for personal use? Would you be suspicious if you drove down the street and saw a sign at McDonald's that said "Over 1 billion burgers sold" and then read the fine print that said "99% of the burgers were bought by franchise owners"? If the vast majority of revenue comes from the sales force, it would seem that the only way to advance in the company would be to recruit additional distributors to purchase the products and recruit other participants. And therein lies the problem.

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Legally, companies are required to generate a substantial amount of

revenue from customers outside the

program.

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With pyramid schemes that try to appear as legit network marketing companies, people under the influence of a faux opportunity might purchase products they



otherwise would never purchase at prices they would never pay at quantities they would never consume...all with the hopes of recruiting others to do the same. When there are hardly any customer sales, the products being sold might be considered "token products" designed to disguise the illegal nature of the endless scheme.

So why are recruitment schemes that look like MLMs dangerous? First, they harm the reputations of everyone in the industry. But mainly, people are harmed in alarming quantities. As an example, let's suppose there’s a network marketing company that sells tap water at $100 per bottle. Theoretically, distributors could purchase this water and mark it up to $120 per bottle for retail sales, thus earning an immediate $20 profit. Since there would be very little demand for this expensive water, it would be unlikely that people unaffiliated with the business would buy the water. Instead, distributors would be forced to focus on finding other distributors and encourage them to buy the water for themselves (“personal consumption”) and recruit others to do the same. Commissions are paid on the downline volume regardless if the products are re-sold to customers.


Totality of the Circumstances

Absent guidance from regulators and legislators, there are some tell-tale signs exhibited by illegitimate operations to help you sniff out the good companies from the bad ones. If you've ever been deep sea fishing, the best indicator of big fish below is surprisingly not an electronic fish finder, it's birds. If there's a bunch of birds picking at a spot in the water, they're eating something...and that something was probably killed by another something you'd like to catch. See one bird? It's probably lost. Two? They're looking. Ten? Cast the line!

Despite my gruesome analogy, there's a point there;) With pyramid schemes, it’s more art than science and you're never totally sure. Although you'll never be able to "see" the fish (sales numbers), you can definitely spot the birds (behavior that's typical with pyramid schemes). When regulators pursue a company, it’s usually a combination of several factors that work in disfavor of the business. If you look at the recent network marketing companies that regulators have shut down, and if you look at how the regulators drafted their lawsuits, you can get a gist of the types of behavior that irks regulators.


So to save you the misery of having to thumb through those court pleadings, I’ve prepared a list of factors to help you tell the difference between good companies from bad. If the business gets past the GOALIE test, you've got a great opportunity.

You've been making purchasing decisions your whole life. You know the value of a dollar. Deep down, you know that paying $3 for a coke is a bad idea. Over the course of your life, we've all developed a spidey sense about the value of our money. We know how far a dollar goes. When analyzing a network marketing opportunity for legitimacy, your gut instinct is probably the most informative factor in the GOALIE test. Ask yourself, “If there was no income opportunity associated with this product, would I still buy it as a customer?" If the answer is “yes,” odds are you’re not alone and you’ve found a good company with a desirable product. It's imperative that direct sellers be able to sell the products to people outside the network. Can a participant (you) make decent money without sponsoring another participant? If the answer is “no,” the design is fatally flawed. If the price is wrong, there will likely be financial incentives for you to endlessly recruit other participants to purchase the products for their own use i.e. buying the $100 tap water and recruiting others. Business models dependent on constant recruitment akin to the Bernie Madoff scheme are untenable, unsustainable and illegal.

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When analyzing a network marketing

opportunity, your gut instinct is the most informative factor.

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Gerald Nehra, a fellow attorney in the industry, once wrote that regulators "look past the paper" when reviewing a company. It takes more than having rules in place ostensibly designed to encourage retail sales...the sales need to actually happen. It's interesting to note that the FTC is undefeated in all of their cases against MLMs...all except for one. In 1979, Amway dodged lightning when the court held Amway was not a pyramid scheme. Similarly, in 2008, the United Kingdom's efforts to shut Amway down were met with similar results. If Amway were a movie character, it would be like Michael Myers of the Halloween series. It appears to die, it comes back, it appears to die, it comes back...creepy in its discipline, its power mysterious. So enough with the pop culture throw back, you're probably asking why I'm referencing Amway in the section about Operational Integrity? Well in 1979, when the court issued its opinion in FTC v. Amway, the court said that Amway's saving grace was its policies and procedures. The court held the policies actually encouraged retail sales, which was contrary to the pyramid allegations. Among the rules, the court


referred to three important ones: the buyback rule, the 70% rule, and the ten customer rule. Since nearly every company has a 70% rule and a good return policy, I want to focus on the most important rule of all: the ten customer rule. Amway's ten customer rule stood for the idea that if a distributor failed to sell products to 10 customers in a given month, they were ineligible for their bonus.

The rule theoretically puts financial pressure on distributors to sell the product to nonparticipants. The rule also puts pressure on the company to offer marketable products at fair prices. The rule is designed to protect both distributors and consumers. If the products do not get bought by nonparticipants, the bonuses get frozen, distributors quit, and all hell breaks loose. It's a great rule...when it's enforced. In some of its lawsuits, the FTC alleged that the companies had rules "ostensibly designed" to encourage retail sales. If those rules are not enforced, they're worthless and disregarded by courts and regulators.


Now this is where you have to "look past the paper" to ensure the company enforces its own policies. As a lawyer in the industry, it's easy to ensure my clients look good on paper. But where I really make a difference for my clients is by advising them to maintain institutional discipline to enforce those rules. If you're presented with a network marketing opportunity, ask your sponsor the following questions:

• Is there a retail sales rule? If the answer is no, that's a factor.

• If there is a retail sales rule, how much product must I sell each month to remain eligible?

• Does the company require you to make these sales, or is there a work-around?

• Do you have a hard time making the sales?

• Have you ever heard of a distributor not receiving a bonus for lack of retail sales?

• Can I see some receipts of your most recent sales?


If your mother is showing you the business plan, it might be tough to ask for proof;) But if you're about to get in business with someone, a business that might require a rolling investment of tens of thousands of dollars, more information is a good thing. And as people in a sales business, they should be able to provide receipts.


If the compensation plan requires you to recruit other participants in order to advance up the pay scale, it's a factor to consider. Ask yourself: "Do I advance my position and potential income potential by recruiting additional distributors down a fixed hierarchy of distributors beneath me, who in turn advance by recruiting other distributors, etc.?" If yes, the result is self-appointment through recruitment to increasing payout levels in the distributor hierarchy. Translation: If a person climbs up the compensation ladder by recruiting active distributors, it strongly suggests a pyramid scheme. An easy example is with forced matrix plans. If a plan is 5 x 5, the only way to advance to the next level is to fill the first level by recruiting 5 active distributors. Retail sales are not part of the equation towards advancing up the pay scale. Advancement requires recruitment. When the financial incentives reward recruitment, the distributors will naturally follow the rewards.

Another example can be found in the marketing plan. If you're being shown a business plan for the MLM, how does the presenter define success? Is it described in terms of customer sales i.e. if you sell x amount of product you earn $y?


Or is success described in terms of the number of distributors in your downline i.e. if you get x people below you, you can earn $y. If advancement is explained in terms of recruitment, it's a factor.


If the business offers a truly unique and remarkable product, one that cannot be found in traditional retail channels, then disregard this factor. However, if the product is a slightly different shade of a similar product at other retail establishments, then a bloated compensation plan makes it difficult for distributors to make retail sales due to the high costs built into the price of the product. One way to check to see if a compensation plan is bloated is to count the number of levels. If there are more than 7 levels in the compensation plan, it's a factor to think about. The rationale is simple. With traditional distribution channels for products (retail stores), the product changes hands a few times before it reaches the consumer i.e. manufacturer, national wholesaler, regional wholesaler, retail store, consumer.

With each link in the chain (or compensation plan), the costs are built into the final price of the product. The more links in a chain, the more expensive the product. Just ask K-Mart. With several levels, companies will be hard pressed to compete with anyone on price, UNLESS the company offers a truly unique product. Although the actual distributor payout is more relevant than the levels in a pay plan i.e. company X pays out 40% of profit to the distributors, distributors are seldom privy to that information. So in the meantime, count the levels.


If the product is truly unique, they can have as many levels as they want so long as there's legitimate demand from consumers outside the distributor network. Although the number of levels is a factor, it's not a determining factor. Really, counting the number of levels in a compensation plan should only confirm what your gut already knows...is the product marketable or is the price inflated due to a fat compensation plan. I've personally represented a company that pays out via several levels while maintaining very competitive prices. It is possible.


Does the company require you to purchase a minimum amount of product each month to remain eligible? If so, it's not necessarily a bad thing. But as with all things,

moderation is important. Inventory loading is a dangerous practice where companies require its distributors to purchase an inordinate amount of product each month to remain eligible for bonuses. It's sort of like waterboarding (but voluntary) where the distributor is forced to consume more than he or she would naturally consume under reasonable circumstances. If a company has excessive inventory requirements, it's a huge red flag for regulators.

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When companies require excessive

inventory, an amount rational people would

never purchase without an income opportunity, they might be trying to

artificially beef up sales by forcing distributors to purchase products.

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Courts have defined inventory loading as, "Occurring when distributors make the minimum required purchases to receive recruitment based bonuses without reselling the products to consumers.” Again, and this point cannot be stressed enough, sales to nonparticipants must occur. When companies require excessive inventory purchases, an amount rational people would never purchase without an income opportunity, they might be trying to artificially beef up sales by forcing their distributors to purchase the products. However, assuming the levels are low, a company can require inventory purchases. For example, if a company has a 10 customer rule, they can require their distributors to purchase sufficient quantities to service 10 customers, assuming the sales to customers are actually occurring.

As an example, prior to Amway making some of its changes, members of its sales force produced a “300 PV household” brochure. It explained how the average distributor could purchase 300 points a month for their own household with no reference to selling. It ended up costing over $900 each month. $900 a month. That's a little high, don't you think? www.theadvocategroup.net www.facebook.com/mlmlaw

Ask your sponsor, "Will I be required to purchase products each month?" If so, ask how much. If the quantity seems steep, there’s a problem. But if the quantity matches the company's retail sales requirement (assuming there is one), it's probably fine. Trust your gut. There's no science here, only art.



Enrollment fees are the costs associated with the registration. In all things business, you’ve got to pay to play. How much are you being asked to pay to enroll in the network marketing company? Registration fees to join the program must not be excessive. In my view, and I advise clients in this regard, registration fees must be tied to legitimate administrative costs born by the company. The act of registration must not be a profit center for the business. Companies cannot charge $400 at sign-up and use that money to compensate its distributors. It would be considered a disguised way of paying a recruitment fee for signing up distributors.

Commissions must only be triggered by product sales. In order to be commissionable, those products must have legitimate demand from people outside the program.

Registration fees and sales aids (training material designed to help distributors sell products i.e. personal websites, company literature, brochure, sales kits, etc) are “non-commissionable” because they’re only relevant for distributors, not for customers outside the network. I’ve heard them referred to as “non-products” because MLM companies are in the business of selling products to consumers, not in the business of training distributors.


The sale of training aids to distributors is done to facilitate those sales to consumers. It’s important to note that separate companies can be created to develop training materials for distributors. But the MLM company itself cannot pay commissions on the sales of these items.

In Burnlounge, the most recent target by the FTC, distributors were required to pay over $400 to join, which included a personalized website (a sales aid). With the personalized website, they were empowered with the ability to sell music to customers through their website. Burnlounge captured the money during registration and allegedly used it to pay its distributors.

Since the personalized websites were only relevant for distributors (it helped them make sales to customers), the FTC argued that the money was improperly paid out to distributors. Remember, commissions can only be paid out when product volume is moved to end-users. The products must be “commissionable” and have legitimate demand from nonparticipants.

If you're pitched a business and the enrollment fee is over $100, I would ask why. If you're getting lots of bells and whistles with your enrollment, it might make sense.


Also check to see if the company pays out a commission when its distributors sell sales aids i.e. personalized websites, brochures, etc. Remember, there’s no need for a costly registration fee and it’s illegal if the company is paying commissions on the sales of training materials.


So did your company make it past the GOALIE test? If so, you've found an outstanding opportunity. If not, at least you know. The GOALIE factors are tell-tale signs to help you distinguish the good companies from the bad ones.

In a perfect world, companies would be required to disclose the percentage of revenue they get from nonparticipants.

If a company gets 30% of their business from customers, it's a good company with a proven product. 50%? Even better. 10%? Danger! However, since we'll never be privy to the sales data, and most companies will never provide it, all we can do is track the signs. The network marketing industry is fabulous. Average people are given excellent opportunities to represent exciting products and change their finances. Network marketing is also a great vehicle to introduce innovative products into the marketplace. When fraudulent schemes masquerade as legitimate companies, it affects the reputations of all companies in the industry. By being informed of the issues and spreading this information to your friends and family, you ensure that these fraudulent schemes lack fertile ground to spread. So go ahead, be a cool person and share this article. Everyone is doing it;)


For more information, please contact Kevin directly at: Kevin [at] theadvocategroup [dot] net. Or call at 615.412.9876. You can read Kevin’s commentary on his blog, Next Generation Law.

Prior to starting The Advocate Group, Kevin gained valuable experience while serving as Chief Counsel for Signature Management Team, LLC, also known as Team. Team is one of the largest providers of sales aids for distributors in the network marketing industry. While at Team, Kevin worked closely with Amway and Mona Vie’s compliance departments to ensure Team’s marketing materials passed regulatory review. Also during his tenure at Team, Kevin helped guide the company through commercial litigation with Amway. He’s recently published a widely read, 80 page ebook on the changing state of the law in the network marketing industry, titled “Defining the Gray.” Read the ebook here, free of charge, to learn more about the laws in the industry.

Kevin is a lawyer, entrepreneur, and agent of change. He’s an MLM attorney and the founder and president of The Advocate Group that specializes in transactional work and start-up formation for network marketing companies. Kevin provides entrepreneurs with the tools necessary to get their businesses successfully off the ground on secure legal footing.

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Legitimate Mlm Or Pyramid Scheme How Can You Tell

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